November was a strong month for the AFINA actively managed products. The top performers were Qualcomm (QCOM), Bed Bath & Beyond (BBBY) and Waddell & Reed Financial (WDR). The Affinity portfolio ended November with a 54% cash weighting while the Optima10 had a cash weighting of 24%.
Qualcomm exhibits our value-oriented strategy of buying great companies. We began buying Qualcomm (QCOM) for the AFINA portfolios in late April 2017. Qualcomm has generated a 14.4% average annual return on invested capital over the past five years and it holds a massive stable of patents that are needed for mobile devices. Qualcomm’s stock price entered a weak period in 2015 and regained weakness into early 2017 after Apple (AAPL) announced that it was withholding nearly $1 billion in payments that it owed Qualcomm. The AAPL-QCOM agreement essentially allowed Apple to use Qualcomm’s intellectual property in Apple’s iPhones and iPads.
Qualcomm undervalued despite patent litigation. Our thesis when we purchased Qualcomm was that its patent portfolio was extremely valuable and it would settle with Apple in an agreement that would still allow it to generate high returns on capital, since management has historically proven to be prudent stewards of allocating capital. It turns out that another company thought that Qualcomm’s patents are valuable too, since Broadcom (BCOM) announced a proposal to acquire Qualcomm on November 6, 2017 in a hostile bid. The Qualcomm shares eventually hit our $69 target price as the Broadcom bid heated up, and we exited our position on November 24, 2017.
An overview of the performance of our actively-managed products is as follows:
As of November 30, 2017. All figures are net of fees and other expenses. Past performance is not indicative of future results. Refer to https://www.afinacapital.com/legal/ for full details and disclosures.
(1) The benchmark represents a 50% weighting of the S&P 500 Total Return Index in Canadian dollars and a 50% weighting of the S&P/TSX Composite Total Return Index in Canadian dollars.
Investing is a marathon, not a sprint
We measure our investing success in 5-to-10 year horizons. In short-time frames we will outperform (2016) and underperform (2017). As it relates to measuring returns over the short term, I had an email from a client that was concerned about our higher cash levels depressing returns in the short-term. While this is clearly a risk as we’ve seen in 2017, most of the cash is earning a 1.20% return in National Bank of Canada’s high interest savings vehicle while we wait for better valuations to return.
Much of our investing universe is fairly-valued to over-valued. We invest in companies that can generate at least a 12% return on invested capital over a 5-to-10 year time frame (similar to how we judge our own investment performance), however, the stock must be undervalued by at least 40% to make it onto our buy list. As a result, if our bottom-up screening and research does not yield undervalued investing opportunities, it gives us a picture of the entire market and sends us a message to be cautious that the market may be overvalued.
Is fixed income a better place to allocate money? As interest rates have fallen since the 1980s, bonds have be in a multi-decade bull market. However, interest rates may have hit a generational low and fixed income returns will likely continue to be under pressure over the next decade as rates rise and bond prices fall. Goldman Sachs recently put together a great chart (see below) that summarizes the ironic confluence of both equities and fixed income appearing expensive at the same time:
- Bonds are represented by the orange line or the US 10-year yield.
- Equities are represented by the dark blue line or the Shiller price/earnings ratio of the S&P 500.
- The scale shown on the left of the chart is the valuation percentile since 1871. Higher readings closer to 100% represents periods where bonds or equities are fully valued. Lower readings closer to 0% represent periods where bonds or equities are inexpensive.
For example, 1981 was a period where bonds and equities were at an extreme of inexpensive. Conversely, we are currently near an extreme of bonds and equities being expensive. We will gladly take the risk of underperforming the market in the short-term if it means that we preserve capital when equities markets enter a correction. There are times to take risk, however, this is not one of those times in our history and the lack of stocks that we can find at the appropriate valuation is a reflection of that reality.